Thursday, September 28, 2006

Two articles in the New York Times this week are nicely complementary. Each looks at long-term trends in the U.S. economy, and in particular what Americans have chosen to spend their money on as they became progressively richer over the past few generations. And each argues that quality improvements have been a major force in driving American consumption patterns.

In the first, David Leonhardt argues that Americans face a tradeoff between better health care and other consumption goods. While he states that the health care system is indeed in crisis, he doesn't worry that increases in health care spending outpace inflation. We get what we pay for, in his view; and although Americans now pay, on average, $5,500 more per year on health care than they did in the 1950's, that's a small price to pay for the increased quality of life we now enjoy.

Robert Frank makes a similar point in an article titled "The More We Make, the Better We Want." He points out that we could now afford the lifestyles of our grandparents with only a fraction of our current income, but we choose not to.

Both articles illustrate a central element that drives economic growth: the insatiability of human desires. When Adam Smith wrote The Wealth of Nations, it was an easy argument to suggest that scarcity is a defining principle of life -- for one thing, just getting enough calories to survive was a challenge for a majority of people. But in an era when obesity is a bigger problem for Americans than hunger, it's reasonable to ask why we continue to work so hard. In the words of Keynes (that Frank quotes), "A point may soon be reached, much sooner perhaps than we are all aware of, when these needs are satisfied in the sense that we prefer to devote our further energies to noneconomic purposes." Clearly that point has come and gone, and yet here I am at work. Why?

Frank argues that the answer to this question lies in the understanding of what "basic needs" are. A theme running through much of his work is that people define their needs in relative terms, rather than absolute terms. Thus everyone might want a "good house in a safe neighborhood," but that might mean something very different in Los Angeles than it means in Baghdad. If the rest of society is driving a Camry, then, almost nobody is going to be happy driving a Model T.

Leonhardt argues that the answer to this question lies in the fact that technology--and in particular, medical technology--extends the boundary of what is possible. Living a healthy, full life means something very different in 2006 than it did in 1950, but taking advantage of modern medicine costs money.

1. Suppose you're in the market for a car, and you know that you want something like a Honda Civic. You come upon a brand new 1980 Honda Civic that had never been driven. You could save a lot of money by buying that car rather than a 2006 Civic. You work an hourly job and can choose how many hours you work. Suppose that if you bought a 2006 Civic and worked for 40 hours a week, you could afford to spend $400 per week on other goods. If you bought the 1980 Civic, you could either choose to still spend $400 on other goods and work fewer hours, or you could continue to work a full 40-hour week and spend more than $400 on other goods. Which of these options would you choose?

2. Suppose you meet a genie who offers you a choice: you can live in the 1950's and earn more than 90% of people, or live in the present and earn the average wage. Which would you choose? What if it were the year 1900? Or 1500? (Before you answer, you might want to pause and think a moment about indoor plumbing.)

3. Suppose a medical research project could extend life expectancy from 80 to 100 years. How much should we, as a society, be willing to pay for that project? What about one that extended life expectancy to 120 years? Or 140? Perhaps an easier question to answer might be: how much would you be willing to pay to extend your own life expectancy? What current consumption would you give up to live an additional year?

Tuesday, September 26, 2006

Managerial innovation often involves the use of new ideas that allow a firm to produce at a lower cost than rival firms and, in turn, earn higher profits. Yet, as word of profitable innovation diffuses, other firms will mimic the innovator until prices adjust and the innovator's initial cost advantage disappears. The labor market for baseball players at the turn of the 21st century offers an example of managerial innovation and diffusion. The innovator, according to Michael Lewis's Moneyball, was the Oakland Athletics headed by general manager (GM) Billy Beane. Beane was the first GM to make use of an idea that was formerly relegated to the realm of baseball stat geeks: the notion that on-base percentage is a much more important indicator of batting performance than baseball managers realized.

Let's assume that professional baseball teams earn more revenue when they win more games. In this case, profit-maximizing baseball teams will strive to maximize the production of wins while keeping the team payroll as low as possible. Winning requires scoring more runs than the opponent. We can think of batters as the run producers. A batter's value to a team is tied to his ability to produce runs and, by extension, wins.

Like any other productive resource, economic theory suggests batters should be paid according to their marginal productivity: that is, the amount their talents contribute to runs scored by the team. Of course, there is no way to measure this amount precisely. So summary statistics, such as batting average (the player's hits divided by at-bats), slugging percentage (the player's total bases divided by at-bats), and on-base percentage (the number of times a player reaches base divided by plate appearances) must be used. GMs must decide how to value each of the various batting attributes so as to acquire batters capable of scoring runs and winning games.

In a recent journal article, economists Jahn Hakes and Raymond Sauer (founder of The Sports Economist blog) show that, at the turn of the 21st century, player pay did not adequately reflect the contribution of on-base percentage to winning games. That is, in paying batters, GMs paid too little for on-base percentage and probably paid too much for other, somewhat less important attributes. Oakland's managerial innovation--emphasizing on-base percentage in the evaluation of prospective batters--exploited the inefficiencies in baseball's labor market and allowed Oakland to acquire players with high on-base percentages at a relatively low cost. As a result, the A's built a series of playoff contending teams but spent much less on payroll than clubs with a similar number of wins. Read the first few pages and the concluding remarks of the Hakes and Sauer article to find out more about the Oakland innovation and how its diffusion changed the labor market for ball-players.

1. According to pages 3 and 4 of the paper, what do batting average, slugging percentage, and on-base percentage measure? Compared to batting average, what additional information about a hitter's productivity does slugging percentage capture? What about on-base percentage? According to the authors, which measure, on-base percentage or slugging percentage, has a bigger impact on wins?

2. What do the authors conclude about the diffusion of Oakland's managerial innovation? Had the value that GMs placed on on-base percentage changed by the time Lewis's Moneyball was published?

3. Steven Levitt, co-author of Freakonomics, criticized Moneyball for over-emphasizing the role of batting and under-emphasizing the role of pitching in Oakland's recent success. Levitt argued that pitching generated most of the A's success. Remember, winning requires scoring more runs than the opponent. Part of a team's success in out-scoring opponents comes from the ability of its pitchers to keep the other team from scoring runs. During the 2000-2004 period, Oakland found a way to acquire inexpensive but productive offense and managed to assemble a stellar pitching staff. Do you think Oakland's offensive innovation helped free up the resources needed to acquire pitching talent?

4. What can the labor market for baseball players tell us about the labor market for corporate executives? Might boards of large corporations mis-price leadership attributes when they determine executive compensation? That is, do corporate boards overvalue certain characteristics of business leaders and undervalue other, potentially more important indicators of competence?

Tuesday, September 19, 2006

Every morning on my way to work, I pass an odd billboard of Abraham Lincoln in front of what appears to be a garage door. The only words I can see on the ad are a URL: http://www.theymissyou.com/. This morning I entered the URL and, voila--it's a rather clever website for a sleep aid medication.

Abe and friends are part of what is called a "teaser" advertising campaign. These campaigns consist of media objects--ads, videos on YouTube, fake MySpace pages--that get one's attention by being a little mysterious. The New York Times has a nice article about how the Lonelygirl15 phenomenon on YouTube has galvanized the teaser ad trade.

(Lonelygirl15 was the screen name of a young woman who posted videos on YouTube like the one above, and who attracted hundreds of thousands of visitors and even some academic speculation. In the end, it turned out to be a film project that might very well become a movie, and its creators have encouraged their fans to "stay tuned.")

The economics of advertising is interesting. Advertising improves economic efficiency by lowering search costs and providing information to consumers, but it also reduces economic efficiency because it is inherently non-productive.

The economics of teaser ads are doubly interesting. Some questions that they bring to my mind are:

1. Teaser ads do not provide any information. Does this mean that they unambiguously decrease economic efficiency? (I don't think so, but I think there's an argument that they do.)

2. One of the difficulties with advertising is that you don't know how many people see an ad. When a teaser ad requires that you go to a website to get the information from the ad, there is a record of how many people view the website. Does this help improve the efficiency in the market for advertising?

3. Many of these ads--in particular the McDonald's Lincoln Fry campaign--are actually quite humorous. Is there a consumption value to advertising? Are ads like works of art? Could it be possible that there are too few ads out there? (Or at least too few good ones?)

(And by the way -- the title of this post comes from the "teaser" question from each episode of the soap opera "Love of Chair.")

Economists typically evaluate any policy change in terms of how it affects efficiency and equity. Normally, economic efficiency means that all profitable trades have taken place. For example, if I value a certain item at $30 and you value it at $50, it is inefficient for me to own the item because you could pay me between $30 and $50 for the item and we would both be better off.

However, one class of economic models, called two-sided matching models (a good introductory read is Al Roth's page at Harvard), defines efficiency somewhat differently. In a two-sided matching model, economic agents don't trade things; they match with one another. Economists use two-sided matching models to analyze college admissions, job search, and even marriage. As proposed by Gale and Shapley in a 1962 paper entitled "College Admissions and the Stability of Marriage," two-sided matching models achieve efficiency when everyone cannot be made better off by rearranging who was matched with whom.

Consider a college admissions scenario with two students, Bart and Lisa, and two colleges, Yale and Harvard. Suppose Bart prefers Yale to Harvard, and Lisa prefers Harvard to Yale. Suppose further that Harvard and Yale are indifferent between the two. Then it would be inefficient for Bart to go to Harvard and Lisa to go to Yale: everyone would be at least as well off, and some would be better off, if they matched up the other way. (This is called a "Pareto improvement.")

In such a scenario, early admission programs improve efficiency. Such a program would allow Bart to signal to Harvard that it was his top choice, and allow Lisa to do the same for Yale. The universities would be better off, too, because they could raise tuition. After all, by definition, universities would be accepting students with the highest willingness to pay.

However, early admission programs increase efficiency at the expense of equity. With many early admissions programs (though not the one that Harvard just ended), a student commits to attending the school if they are accepted. Consequently, students who were admitted early could not compare financial aid offers from multiple schools. Students from low-income families are therefore at a distinct disadvantage, since they are more likely to be sensitive to price relative to other factors in making their college choices. In the words of Harvard's interim president, Derek Bok, "the existing process has been shown to advantage those who are already advantaged."

So, we might think that Harvard's move will decrease economic efficiency but increase equity. But there's one more catch: Harvard is one of the very top schools in the country. As a consequence, it may be very certain that all students would rank it as #1. In this case, it doesn't need an early admissions program to extract the preferences of applicants -- it can just go ahead and choose the students it likes the best, knowing that they too will generally accept its offer. Indeed, according to one study by Christopher Avery, Mark Glickman, Caroline Hoxby, and Andrew Metrick, Harvard does not need to engage in "strategic admissions practices," while even Yale and Princeton do. (See the graph on page 7, and the discussion on page 6. UPDATE: A New York Times article over the weekend elaborates on this point.) So while Harvard certainly deserves credit for shifting to a more equitable policy, it remains to be seen how contagious its sneeze will be.

1. Does Harvard's move make the admission process completely equitable? Why might low-income students still be at a disadvantage in college admissions?

2. Suppose all colleges were to abandon their early decision programs. Would students be better off? Would colleges? Why?

3. Suppose all students were to submit a ranking of all the colleges they applied to along with each of their college applications. If you were a college admissions officer, how would you use that information in deciding whom to admit, and what kind of financial aid package to give them?

4. A similar problem to the college admissions problem is the assignment of medical students to residency programs. Unlike college admissions, this is arranged through a centralized process called the National Residents Matching Program. It works like this: students submit a list ranking their prospective programs, and residency programs submit a list ranking students. A computer algorithm then matches students to programs. Do you think a similar program would work well for college admissions? Why or why not?

Tuesday, September 12, 2006

In 1995, Christopher Buckley gave a speech at the Yale Daily News banquet. Afterwards, he wrote an angry op-ed in The New York Times called "Bombed in New Haven." Said Buckley at the time, "We knew how to party in my day, too." But:

The scene that greeted me in the dining room at the New Haven Lawn Club was out of a putsch in a Munich beer hall, minus the brown shirts and funny salutes. The leaders were bellowing so loudly that you had to shout to converse with your dinner partner. At one table, a fifth of vodka was being passed around and glugged from. At another table, a woman was slumped over her boyfriend, unconscious. Well, they had been drinking since 5 in the afternoon. Apparently the trend these days is to "front-load," that is, go to a party before the event and get so tanked that you will feel no pain later on. Or be aware that there is a guest speaker.

Of course, college students are used to being lectured about how excessive drinking is risky to one's health. According to economists Michael Kremer and Dan Levy, though, it may also be dangerous for one's GPA.

Kremer and Levy examined how alcohol use among college students affects academic performance. In short, they asked: What happens to a student's GPA if they are randomly assigned to a roommate who drinks? Read the abstract, introduction, and conclusions (skip the technical mid-section) of Kremer and Levy's research paper to find out. (Note that the authors get at a deeper economic question in the paper: Do peers influence the way people form consumption preferences?)

1. What happens to the college GPAs of young men who share dorm rooms with frequent drinkers? Is the effect stronger for male students at the top (high high-school GPA) or bottom (relatively low high-school GPA) of the GPA distribution?

2. What happens to the college GPA of a young man who drank frequently in high school when he is assigned to a dorm room with a fellow drinker?

3. How does the GPA effect of rooming with a drinker play out over time? Do Kremer and Levy find that the effect on GPA is stronger in the first year of college or in the second or subsequent years?

4. Do the authors find any evidence that a drinking roommate affects the college GPAs of young women?

5. Suppose a university establishes substance-free housing. How will this affect GPAs of students who self-select into the substance-free dorm rooms? What types of students will end up rooming together in the not-so-substance free dorms? How might such segregation impact the average GPA at the university?